Investors need to be a little cautious of the recent rally in real estate stocks, led largely by the anticipation that a business-friendly government will assume power.

Real estate companies such as HDIL, Unitech, DB Realty and Indiabulls Real Estate have surged 25-80% in the past three months, fueling expectations of more to come.

But going by the BJP manifesto, urban realty players may not have much to look forward to. According to the manifesto, the new government will be focusing on creating 100 new cities and affordable housing, which may not augur well for the debt-trapped urban realty developers, which already have projects lined up.

A quick reality check reveals that such rallies in these stocks in the past soon ran out of steam. In the past, the BSE Realty Index gained much more than the Sensex in the rallies, only to underperform and give negative returns thereafter (See chart). For instance, the index gained 50% between September 2012 and January 2013, but then sharply corrected by 50% over the next few months, negating all the gains. While most of the stocks lost much more than they had gained, some continued to gain after a mild correction.

Here's a quick check on realty stocks.

Best of the lot: Oberoi Realty, Prestige Estates and Sobha Developers These companies have strong balance sheets (low debt) and cash flow visibilities, primarily from office and retail assets and residential projects that have crossed 25% of the construction stage. They have a proven execution track record and also score high on corporate governance issues. Prestige and Sobha also benefit from the strong Bangalore realty market, where the price per unit area is still the lowest among cities, affordability is high and demand is strong. The Mumbai-based Oberoi Realty gains from its strong brand in the slow city market. Although fairly valued at current levels, these stocks are potential winners in the real estate segment over the next 2-3 years, given their strong fundamentals.

High-risk bets - DLF, Indiabulls Real Estate and Godrej Properties Although these companies are primarily urban developers and may not benefit from weak prices, these could be a strong de-leveraging bets and could attract highest investor interest, after the elections. Although high on debt, DLF and Godrej Properties are in the process of de-leveraging. In the past six months, DLF and Godrej have reduced their debt by asset sale and rights issues, respectively. Lower interest outgo and better project mix in coming years can improve their earnings. In case of Indiabulls Real Estate, analysts are expecting its earnings to grow by over 50% compounded annual growth rate over the next three years due to a strong project pipeline.At the same time, these stocks are more liquid and will interest institutions. The current prices/valuations of these stocks do not entirely factor in the potential rise in the earnings and cash flows.

Avoid - HDIL, Unitech & DB Realty Not much has changed for these companies over the past few quarters. However, these stocks have gained the most in the recent rally.

Mumbai-based HDIL and DB Realty have gained 80% and 30%, respectively, in the past two months while Delhi-based Unitech has jumped 30% during the same time. However, analysts are sceptical about future earnings of these companies.

While HDIL has marginally reduced its debt in the past quarter, and the Street is expecting Unitech to sell some of its assets, these companies still have the highest debtto-earnings ratio in the listed realty segment, and continue to struggle with slow sales. Besides, the strong run-up has made these stocks expensive and investors can avoid them as they will continue to struggle with high debt and lower earnings, going ahead.